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Monday, 13 August 2012

Discuss the methods of credit creation and what are the limitations of credit creation






MEANING OF CREDIT CREATION :-
The commercial banks create multiple expansion of their bank deposits and due to this, these are called the factories of credit. The banks advance a major portion of their, deposits to the borrowers and keep a smaller part with them. The customers have full confidence on the bank. The banks expand loans by much more than the amount of cash possessed by them. This tendency on the part of the banks to lend more than the amount of cash possessed by them is called Creation of credit in Economics.


BANKS CREATE CREDIT IN TWO WAYS :-
1. By over drafting.
2. By purchase of securities.

By over drafting bank creates credit. Secondly bank purchases the securities and pays them with its own cheques. The holders of these cheques deposit them in the same banks. This creates deposit which is nothing other than creation of credit.

According to Benhen : " A bank may receive interest simply by permitting a customer to overdraw their account or by purchasing securities and having for them with its own cheques. Thus increasing the total bank drafts. One should remember that single bank creates a very little credit. It is a whole banking system which can expand the credit."

Secondly when loans is advanced, it is not given in cash. The bank opens a deposit account in the name of the borrower and allows him draw to draw whenever required. The loan advanced by cheques results in the creation of new demand deposits. Sometimes, a question arises that it borrowers with draw these deposits for the repayment to other persons, then how the banks will create credit. The answer is that other persons who receive money may also be the clients of the bank. Naturally they will also deposit their cash in the bank. The process remains continue. We can explain it by the following example .

Example :-  Suppose a person deposits 1,000 in a bank. According to experience bank can keep 20% cash reserve to meet the demands of the depositors, and can lend the rest safely to the borrowers. If all the bank maintain a reserve ratio of 20% then banks can succeed in creating a credit a credit of Rs. 5000 against an original deposit of Rs. 1,000 in cash.


CONTRACTION OF CREDIT :-
The contraction of credit adversely affects the money supply. The contraction of bank credit may take place due to many visions. For example the bank may recall loans or due to political uncertainty or due to fall in price borrower may stop the borrowing.

According to Pritchard : " Contraction by any single bank in this system will place pressure on other banks and if their excess reserve position is inadequate and the banks are unable to meet their excess reserves through the agency of the central bank then a multiple process of credit contraction will start."


LIMITATION OF CREDIT :-
Banks have not unlimited credit creation powers. There are so many restrictions which can be discussed as under :

1. Restriction By The Central Bank :-
If the banks have large deposits they can create more credit and if they have small deposits then their power of credit creation will be limited. While we know the commercial bank has the monopoly of note issue, if the central bank increase the quantity of money the deposits of commercial banks will increase and they will expand the volume of credit in the enquiry. On the other hand if supply of money decreases, the volume of credit also of decreases. Any how the credit creation power of the commercial bank is directly affected by the policy of the central bank.

2. Habits Of The Customers :-
The power to create credit by the commercial banks is very much influenced by the habits of the people living in that country. If the people are habitual in using the cheques then the volume of credit will expand on the other it will be contracted.

3. The Cash Ratio :-
Every bank keeps an adequate cash reserves for meeting the cash requirements of its customers. The bank will not allow its cash ratio to fall below a certain minimum level. When this level is reached then bank will not advance money.

4. The Collateral Security Available :-
The bank advances loan to the borrowers against some kind of Collateral Security. If these are not available then the power of credit creation will be restricted.

These were some limitations in the way of credit creation.

4 comments:

Anonymous,  27 February 2013 at 06:46  

I think the bank makes money through three ways as follows;
1)when they receive an initial deposit
2)When they give out loans
3)When they buy securities on cheques drawn in their name.

Please try and review your blog. Thanks

Anonymous,  21 September 2013 at 06:26  

I think a bank can make money through:
1. making advances/ loans( from deposits received.

2. buying assets e.g securities

3. by overdrafting

Anonymous,  21 September 2013 at 06:28  

I think a bank can make money through:
1. making advances/ loans( from deposits received.

2. buying assets e.g securities

3. by overdrafting

david muthomi 16 November 2015 at 04:06  

credit creation gives an opportunity for development of a bank and the state

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